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Treaty not a safe option but a perilous experiment

Wed, May 2, 2012, 01:00

TERRENCE McDONOUGH

OPINION: IRELAND MAY well need a second bailout after 2013. And as treaties are currently worded, a No vote on the fiscal compact treaty will forbid us from accessing funds from the European Stability Mechanism (ESM).

It is claimed this situation will result in disaster, and that even if we believe the fiscal treaty is a serious mistake, we have a gun to our head. In fact, Ireland will have a number of options in this event.

First, Ireland is certainly small – but it is still scary. A disorderly Irish default would threaten the stability of the European banking system. A European Central Bank intervention to restabilise the system would be considerably more expensive than a second bailout of what is a small country. It is highly unlikely Europe would ignore its self-interest in order to spite the Irish electorate.

Funds would be found outside of the ESM. The European Financial Stability Facility (EFSF), for example, is accepting applications for new money up to the middle of 2013 and will stay open to administer this money in subsequent years.

Secondly, Ireland also has the option of borrowing from the International Monetary Fund rather than the European institutions. The Department of Finance was forced to admit this over the weekend when the IMF said as much. It has been pointed out Ireland is entitled only to apply for the money. But this would also be the case with the ESM.

A third possibility is to set about partially closing the budget deficit. The Irish tax take as a percentage of gross domestic product (GDP) is well below the EU average. Taxes on wealth and high incomes are considerably under-exploited.

A fourth possibility is the restructuring of debt. The Anglo-Irish promissory note payments alone constitute €3 billion in any given year. Most commentators outside Ireland believe restructuring of some sort will eventually take place in any event.

A fifth, under-discussed, possibility is the issuance of innovative debt instruments. It would be possible to make Irish bonds acceptable in payment of taxes in the event of any default. This should eliminate the risk premium which makes it difficult for Ireland to re-enter the markets at this time.

A judicious combination of these strategies would be better than relying solely on any one of them. In the event of a second bailout, the resulting gap can be closed in this way.

The sky will not fall in in the event of a No vote. Many pro-treaty arguments are primarily intended to be calming and reassuring in nature, telling the electorate a Yes vote is the safe and conservative course. In fact, such a pact is historically unprecedented – and for good reason.

The treaty is not simply “good housekeeping”. Countries are not like households. Every first-year economics student knows about John Maynard Keynes’s paradox of thrift. If a country tries to save by cutting spending, its economy shrinks, drying up the potential savings.

Budgets need to be adjusted over the business cycle. Aggressive budget balancing at the bottom of a depression is simply counter-productive. This means implementing the treaty will destabilise the euro zone and eventually undermine market confidence.

Let’s consider again what’s on the table.

1. Structural deficits for Ireland should be about half of 1 per cent of GDP, with a 3 per cent top limit on the headline deficit even in the worst years. This requirement seriously compromises government ability to end recessions.

The implementation of the 0.5 per cent structural deficit rule in the new treaty is considerably more stringent than any of the existing “six-pack” regulations, which are themselves unwise. Eventually, a shortage of government bonds will emerge, forcing conservative investors such as pension funds into less safe investments, risking the reappearance of dangerous asset bubbles.

2. Debt should be 60 per cent of GDP. If debt is greater than 60 per cent, it will be reduced by 1/20 per year over the next 20 years. This would start in 2018, when the bailout terms expire, and could require up to €5 billion a year in savings to 2038.

3. Even after we reach this target, Ireland will be forced to run primary surpluses, that is excluding interest payments on the national debt, for many years, taking steam out of the economy.

4. If these conditions are violated, control over fiscal policy is ceded to Europe and the European Court of Justice.

Take a country at the bottom of a depression. Force it to run budget cuts and tax increases year after year after year. Force this same policy on its neighbours and trading partners. Run this into the foreseeable future and hope it results in stability, confidence and recovery. This is emphatically not the safe option. This is a dangerous experiment, completely without historical precedent.

It is sometimes argued this treaty is a first small step in the direction of a more ambitious programme to reform the euro zone. It would be more accurate to say the fiscal treaty is a strategy adopted instead of such needed changes.

It is argued, mistakenly, that the adoption of these budgetary rules will make eurobonds, European Central Bank reform, debt relief, a transfer union, and policy change in surplus countries unnecessary. Thus this treaty makes serious reform less, not more, likely.

The “common sense” regarding the fiscal treaty retailed by the Government is at direct right angles to reality. There will be no disaster in the event of the need for a second bailout. It is the adoption of the budget provisions of the treaty which is a risky and perilous experiment.